Romney vs. Obama on corporate tax reform

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Article Highlights

  • Recent study shows that union wage premiums in #US increase sharply when state corporate income tax rates go down

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  • Corporate tax depresses investment in the domestic economy, reducing productivity & ultimately workers' wages

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  • Santorum follows #Obama's incorrect lead & introduces a significant economic distortion

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The one thing on which our political leaders seem to agree is the need for corporate tax reform. Barack Obama and Mitt Romney unveiled new proposals on the same day last month, with President Obama cutting the top corporate tax rate to 28% and Mr. Romney reducing it to 25%. Rick Santorum would cut the rate to 17.5%, and to zero for manufacturing. Congressional action is bubbling below the surface as well.

This flurry of proposals is a result of increased awareness of how out of step America is with the rest of the world. The U.S. is currently an outlier within the 34-member Organization for Economic Cooperation and Development, with a combined state and local corporate tax rate that is about 15 percentage points higher than the average of our trading partners.

But amid all of the promising rhetoric there is significant cause for concern. Many proposals, particularly those of Messrs. Obama and Santorum, seem to have unlearned many of the lessons of modern economics.

An explosion of recent empirical work documents that labor bears much of-and, in some analyses, all of-the burden of the corporate tax.

Three shifts in the economic environment since the 1960s, each recognized by most economists, provide an essential guide to reform.

First, U.S. tax policy can no longer treat the U.S. as a closed economy. Capital and business activity are increasingly mobile across national boundaries and highly responsive to variation in the net tax paid across locations. Second, the word "business" is not synonymous with "corporation"-pass-through (noncorporate) businesses are almost as important in the aggregate as old-fashioned corporations. Third, economic research has stressed that both corporate taxes and investor-level taxes on dividends and capital gains contribute to the tax burden on corporate equity. Investors factor in the total capital tax, both individual and firm level, when making decisions.

A key implication of the first point is that the rapid increase in international capital mobility has significantly altered the calculus of redistributive policies. Conventional analyses of who bears the burden of the corporate tax conclude that the tax is borne by owners of domestic capital.

But an explosion of recent empirical work documents that labor bears much of-and, in some analyses, all of-the burden of the corporate tax. This is because the corporate tax depresses investment in the domestic economy, reducing productivity and ultimately workers' wages.

The effects even spread to the union sector. A recent study by economists R. Alison Felix and James R. Hines shows that union wage premiums in the U.S. increase sharply when state corporate income tax rates go down.

Mr. Obama's plan, as if designed by Rip Van Winkle, is blind to this major shift and is thus a weak tonic for the flagging economic recovery. While the president proposes reducing the corporate tax rate, other changes that are portrayed as "loophole closing" on multinational firms make his plan a net increase in corporate taxes collected.

Mr. Obama, ignoring the second reality, would also raise taxes on noncorporate business, in the interest of requiring the "rich" to pay for the "privilege" of being an American, to paraphrase a recent statement by Treasury Secretary Tim Geithner. Noncorporate business accounts for 36% of business receipts, 44% of business taxes, and 54% of private-sector employment.

A unifying characteristic of the many types of noncorporate businesses is that their owners pay taxes at individual rates. A substantial body of economic research has found that changes in individual marginal tax rates clearly impact noncorporate firms' investment levels, hiring practices and wages.

In addition, Austan Goolsbee, the former chairman of Mr. Obama's Council of Economic Advisers, did pioneering work in the early 2000s documenting that the organizational form of firms is highly responsive to tax changes, arguing at the time that this significantly increases the likely deadweight loss associated with the corporate tax. Mr. Goolsbee's work suggests that the Obama proposal would cause costly reorganization.

While cutting corporate tax rates with his left hand, Mr. Obama would increase tax rates with his right by radically increasing tax rates on dividends and capital gains. Modern economic theory and empirical evidence-including a series of papers by one of us (Hassett) and Alan Auerbach of the University of California, Berkeley-show that raising taxes on dividends at the individual level increases the cost of equity capital and lowers asset prices, harming consumers while hindering firms' ability to hire workers.

The plans of Messrs. Romney and Santorum have significantly more promise. Both would bring down rates on corporate and noncorporate income, though only Mr. Romney would do so in a revenue-neutral way (the Santorum plan adds greatly to federal deficits). According to one study, a top marginal tax rate on individual incomes of 28% as proposed by Mr. Romney, compared with Mr. Obama's proposed top marginal rate of 39.6%, would increase the wage bill of noncorporate businesses by over 6%, raise investment by 10%, and push business receipts up by 16%.

And by proposing special tax breaks for manufacturing, Mr. Santorum follows Mr. Obama's incorrect lead and introduces a significant economic distortion. In a world with highly mobile capital, tax policy needs to be neutral toward different forms of business activity and not succumb to the temptation to pick winners and losers. We are aware of no serious economic argument to support such a policy direction.

A 21st-century business tax policy would recognize the roles of globalization, the side-by-side organizations of corporate and noncorporate business, and double taxation of corporate equity returns. Mr. Obama's tax reform proposal takes a wrong turn in each area and appears motivated by a poor understanding of the impact of capital taxation on business behavior and the welfare of middle-class Americans.

It is reassuring that political leaders on both sides of the aisle recognize the need for corporate tax reform. Let us hope that the reform that eventually becomes law is attentive to the realities of the 21st-century economy.

Kevin Hassett is a senior fellow and director of economic policy studies at AEI. Glenn Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush. He is an economic adviser to Mitt Romney. 

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About the Author

 

Kevin A.
Hassett
  • Kevin A. Hassett is the State Farm James Q. Wilson Chair in American Politics and Culture at the American Enterprise Institute (AEI). He is also a resident scholar and AEI's director of economic policy studies.



    Before joining AEI, Hassett was a senior economist at the Board of Governors of the Federal Reserve System and an associate professor of economics and finance at Columbia (University) Business School. He served as a policy consultant to the US Department of the Treasury during the George H. W. Bush and Bill Clinton administrations.

    Hassett has also been an economic adviser to presidential candidates since 2000, when he became the chief economic adviser to Senator John McCain during that year's presidential primaries. He served as an economic adviser to the George W. Bush 2004 presidential campaign, a senior economic adviser to the McCain 2008 presidential campaign, and an economic adviser to the Mitt Romney 2012 presidential campaign.

    Hassett is the author or editor of many books, among them "Rethinking Competitiveness" (2012), "Toward Fundamental Tax Reform" (2005), "Bubbleology: The New Science of Stock Market Winners and Losers" (2002), and "Inequality and Tax Policy" (2001). He is also a columnist for National Review and has written for Bloomberg.

    Hassett frequently appears on Bloomberg radio and TV, CNBC, CNN, Fox News Channel, NPR, and "PBS NewsHour," among others. He is also often quoted by, and his opinion pieces have been published in, the Los Angeles Times, The New York Times, The Wall Street Journal, and The Washington Post.

    Hassett has a Ph.D. in economics from the University of Pennsylvania and a B.A. in economics from Swarthmore College.

  • Phone: 202-862-7157
    Email: khassett@aei.org
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    Name: Emma Bennett
    Phone: 202-862-5862
    Email: emma.bennett@aei.org

 

R. Glenn
Hubbard
  • Glenn Hubbard, a former chairman of the President's Council of Economic Advisers, is currently the dean of Columbia Business School. He specializes in public and corporate finance and financial markets and institutions. He has written more than ninety articles and books, including two textbooks, on corporate finance, investment decisions, banking, energy economics, and public policy. He has served as a deputy assistant secretary at the U.S. Treasury Department and as a consultant to, among others, the Federal Reserve Board and the Federal Reserve Bank of New York.
  • Assistant Info

    Name: Brittany Pineros
    Email: brittany.pineros@aei.org

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